Anyone who cares about the health of the US economy should welcome the enactment of the Treasury’s rescue plan for Fannie Mae and Freddie Mac, along with other measures to support the housing market. While there is room for argument about details, the risks to the financial system were too great to allow delay.

The rescue should be treated as an unfortunate necessity, but Summers salutes nevertheless. The article appears to set up a “so what do we do with the GSEs now?” but wimps out, although I am sure he would not see it that way. He proposes no action on Freddie and Fannie, despite the intervention, unless the GSEs continue to require government back-up to fund at a favorable rate. In that event, the Feds can use their receivership powers, wipe out shareholders and sub debt, and break up the GSEs. The problem is this will NOT happen if the GSEs continue to have a government backstop and depend on the now -explicit guarantee; it may not even happen if they need support but the damage is not too large.

I used the word escalation quite deliberately to describe this mess. If the GSEs can manage their affairs so that no dramatic increase in support is required, I suspect the Feds will prove quite reluctant to nationalize them. Only a plan to do so now might have worked, and the moment has passed.

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The United States has come to a fork in the road where the decision to take path A or B is the most important national decision for 50 years. This July is one year on from the start of the credit crisis and as the extent of the problems has unfolded there are two clear options:

A) Save the housing marketB) Prevent a dollar collapse

Because the housing market is a here-and-now problem, especially in an election year, a dispassionate choice is not being made. The unseemly haste with which the GSE’s are being propped up and housing stimulus packages slammed together is shameful. And to what end? To prevent housing returning to 2002 levels? To bail out foreign investors in MBS? Yes. There are some good points here. But at what cost? The huge increase in national debt and negative real interest rates will decimate the value of the dollar – particularly its world reserve currency status. This is a disaster. The British pound was the world’s reserve currency for 150 years until 1940. Allowing that country to punch well above its weight. The dollar superceded it from the 1940s. The transition was quick. The hasty housing bailout, negative interest rates deflationary combination will destroy the dollars reserve currency status from 2010. It will be replaced by an informal basket of other currencies – an even to be regretted long after house prices have returned and passed the 2006 peak.

So wintermute, broadly I agree with everything you say, and certainly your remarks are accurate as made. It is not out of the question that the dollar could rebound as a reserve currency, however, even if it fails for a time. Britain actually briefly lost its currency status at the outset of the Wars of the French Revolution. The Brits lost a ton of money, and had huge trade problems. Two things saved them. With the Continent at war, there was no serious rival. And the war economy itself allowed the British government to float a massive amount of public debt to fund the war effort, which actually put a floor under their financial system of the time again, and allowed them to reflate.

Furthermore, the UK was in many respects busted by the Great War. Their debts were huge; their industry was already behind and never caught up. But the US dollar was not an international currency of account prior to the war, the Federal Reserve was very new and had only just begun to permanently stabilize the notoriously bust-prone US financial system, and politically the US was not minded to fund ‘furriners.’ So the US propped up the UK through the Twenties, really. But the pound was already in deep trouble from 1915 on.

The present situation for the US is different, however. Yes, the EU and China will suffer greatly in the American economy tanks, but they are far more in a position to ‘hold market share’ and otherwise make trade and currency gains if the US is flat on its arse in the gutter. On the other hand, if when and as the US economy recovers, it is and will still be the largest unified and liquid economy in the world, which is a great fulcrum. Unless the EU gets itself together in the interim with a unified regulatory regime and tightly controlled sovereign bond market. It would take extraordinarily shrewd management by the US to regain reserve status if it is lost for a time, but a weighted basket is a straw opponent: nobody will or really can defend it. I don’t think the US has that kind of leadership, though. Rather, we are likely to pander to domestic constituencies in financially irresponsible ways which will hurt our debt and currency, giving our sovereign financial authorities too weak a hand to play. But they may yet make a game of it. The US as a major economy is not going to go away even if we kill our currency. What will go away is much of our geopolitical cred and leverage. We’ll be a player, just not the player. —And if we try to fight our way back to the top with military means, look out.